Understanding Personal Finance: Banking, Insurance, and Taxation, Study notes of Financial Economics

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Personal Finance

Supplementary Reading

Material

Department of Education in Social Sciences

National Council of Educational Research and Training

New Delhi

Contents

• 1. Financial Plan 1- Chapters Page No.
• 2. Budgeting 9-
• 3. Managing Your Money 17-
• 4. Financing Assets 39-
• 5. Protection of Assets 53-
• 6. Investing Money 73-
• 7. Retirement Planning 85-
• 8. Taxes and You 98-
• 9. Career Planning 112-

Department of Education in Social Sciences

NCERT, New Delhi

Team Members

Ashita Raveendran Jaya Singh

Minoo Nandrajog M.V. Srinivasan

Neeraja Rashmi Shipra Vaidya

Acknowledgements

We are grateful to the following for their comments and suggestions during

the workshop: Prawin Kumar and Monika Bhatia from the Department of

Income Tax, M.M. Goel and J. Khunthia from the University of Delhi, Neeti

Agrawal, Kamal Vagrecha and Subodh Kesharwani from the IGNOU,

Sashikala from Mount Carmel School, Shrutibodh Aggarwal from Delhi

Administration and Shobhna Nair from Mother's International School.

plan, you will have to think about your needs and then accordingly prioritise your goals. Thus, the process of financial planning will include two steps: (i) to specify your goals, and (ii) to describe your spending, financing and investing plans to achieve those goals. Financial planning helps you to ensure that you will have funds available to meet your present as well as future needs.

In India, there is a culture of saving for some future event or contingency or an asset to be acquired. Usually, some money is kept aside for this if it is surplus. In the middle income groups, there may be little or no savings due to high prices of essential items. This is where it becomes important to think of a personal financial plan. In contrast in advanced countries, like America, individuals tend to rely too much on credit cards which sometimes puts them in debt. They do not think of saving money and usually spend all their monthly income. Despite the difference in the cultural as well as economic position of the countries all individuals need to plan their finances in order to have some surplus and avoid debt.

When people or households do not have any savings, it becomes problematic in difficult times or emergencies like paying for hospital expenses, repairs in case of accident or other necessities. Similarly, if you have savings then there are numerous options to channelise your savings such as like bank deposits, insurance plans, shares etc. Thus, being financially prepared for such exigencies makes life much easier. Once you have a financial plan, a lot of financial issues relating to savings and expenses get streamlined.

Why Personal Finance The main purpose of personal finance education is to positively influence financial behaviour. It has been observed that such education is delivered more effectively to younger children than to their older counterparts. Knowledge of personal finance is beneficial for everyone in many ways.

Make your own financial decisions An understanding of personal finance helps you take informed decisions about your financial situation. When you spend money on a particular thing you are giving up something else. For example, if you purchase a book for `. 500/- you are sacrificing maybe, a video game of the same amount or you could have saved that money for the future. There are various alternatives which you could have considered and you have to choose one and forgo the others. What you give up as a result of your buying decision is what we call opportunity cost. Evaluate the advice of financial advisors You may have come across various insurance agents, trying to sell policies or agents for different mutual funds. If you are aware of financial matters then it becomes easy to assess the various alternatives given by financial advisors. Financial advisors usually give you advice and guide you on your savings and investment. They may sometimes make false claims and guarantee high returns on particular investments. Your understanding of personal finance will enable you to determine whether their advice is in your best interests or theirs. Become a financial advisor There are many people who do not understand financial matters or are not interested in taking financial decisions at all. At times, many employees go on paying high taxes because they do not know that by investing in certain securities or contributing to their provident funds they may save on taxes. There is a demand for financial advisors and a course in personal finance or other finance related courses can help you pursue a career as a financial advisor. They usually charge a commission on the amount of investment made from the source of the securities, for example, the post office or the company connected with the mutual funds. At a later stage, if they are enterprising and have a good understanding of financial matters they get paid for their specialised knowledge. Instilling Financial Discipline All of us need to be disciplined when it comes to spending money. If you have to live with a limited income your expenses have to be regulated. Same is true for your pocket money; you have to make sure your money lasts through the whole month. Parents have to make sure that the money is not misused and is judiciously spent.

Components of a Financial Plan In a financial plan there are personal finance decisions related to six major areas. i) Budgeting ii) Managing your money iii) Financing large purchases iv) Protecting assets v) Investing money vi) Planning your retirement vii) Tax Planning

Budgeting We have heard people say that spending is going out of our budget. What is a budget? A budget is a statement of your income, expenses and saving. Budgeting therefore, is the process of forecasting future income and expenses for a given period. The surplus shown in your budget would be savings. Savings may be less or more depending upon how much you spend. Budgeting can therefore help you estimate how much of your income is required for monthly expenses and how much you will be able to save each month. You may use your saving for investing in bank deposits or in the financial markets or purchasing an asset such as a car or paying off your loan. Budgeting is a process where you evaluate your current financial position by assessing your income, expenses, assets and liabilities. Your budget is influenced by your income because you can only spend what you earn. Then the next step in the budgeting process is to estimate your expenses to be incurred every month. If you are able keep current expenditure levels low, your savings will be higher and you will be able to accumulate wealth in the future. Budget is the foundation of your financial plan, as it provides a base for making personal financial decisions.

Managing your money You need cash to meet your daily expenses. Cash is required for daily minor expenses as well as major contingencies like repairs or medical treatment etc. For all this access to funds is necessary to cover any short-term cash needs. Your liquidity position is basically

determined by how much cash you have in hand or what can be accessed immediately. Money management and credit management are two techniques to enhance your liquidity position. Money management involves decisions regarding how much money to carry in liquid form and how much to allocate to short-term investment. Credit management involves decisions about how much credit you need to support your spending and the sources of credit to use. If you fall short of money then what other sources can you fall back on? Can you go to a bank, friends, employer or credit card facility? Credit card facilities should be used less as interest rates are exorbitant. It is normally used to cover expenses that cannot be covered by current income.

Financing large purchases Huge expenditures like purchase of a car or a house often are financed by a loan. How much loan to take will depend upon your savings and the purchase price of the assets. The capacity to repay the loan is also an important consideration. Loans are available in easy instalment of monthly, six monthly or annual system of repayment. The interest rate charged also is different for different schemes of loan and its repayment. There are, therefore, four things to consider: (i) how much loan to take, (ii) Maturity or length of the loan (iii) Interest rate and (iv) Instalment plan.

Protecting assets Insurance plans are available to protect your assets. Insurance companies offer different types of insurance policies with varying amounts of premium to be paid depending on the risk associated. Car insurance, house insurance, health insurance are some of the popular policies for different amounts.

Investing money The extra funds which you have can be invested in shares, bonds, mutual funds and property to earn a higher return. You may invest your saving in bank deposits for different periods with varied rates of interest if you wish to opt for a safe investment. Or if you are willing to take risk you may invest in the capital market, i.e., in shares or bonds

to be reviewed. New offers like online investments, digital tax returns can be some of the change agents, we may have to learn to live with. Financial plans help in judiciously allocating money in different assets. Buy Life Insurance Buy the cover that you need today. Remember to get the terms plan first so that the sums assured is adequate for your family needs. Close all unnecessary bank accounts How many of us opened new bank accounts with each new job and haven’t even checked the balance in these accounts in the past one year. Pay full credit cards bill on due date Remember if you do not pay the entire bill on the due date, interest is charged from the date of spending and not the due date for payment. That factor alone can push up the credit rate to over 40% per annum and this makes it probably the most expensive form of credit. Source: The Economics Times

As evident, children are fast becoming part of the financial decision making process in their families. Awareness of personal finance enables them to reflect upon crucial details such as interest rates, mortgages, credit cards, saving, investment and expenditure and helps them to prepare for uncertainty in life. The value of living within one’s means and saving as much money provides for a good financial outcome as well as a guarantee for the future.

CHAPTER 2

BUDGETING

When we get cash in the form of pocket money from our parents or salary from our employer on the first of every month, it seems to disappear very fast. What did we spend it on? We have nothing to show for it. This happens because we do not correctly assess our expenses and plan accordingly. Therefore, we need to be in control of our personal finances.

If we make a budget, a statement showing cash flows and a personal balance sheet we know what our position is and what further steps may be taken to control the situation. A budget, as we all know, is a statement showing future income, expenses and savings. It is based on some estimates.

These estimates are one income which are our source of cash inflows and expenses which are cash outflows. We need to prepare a personal cash flow statement which measures cash inflows and cash outflows. By keeping a check on our cash outflows we may be able to monitor our spending and allocate some amount towards savings.

Cash Inflows – Where does our cash come from? For working people, salary is the main source of cash inflows. Other sources may be interest from bank deposits, dividends on shares or rent from property.

Cash Outflows – Where does our cash go? Cash outflows are in the form of expenses. Expenses will include both large and small. In our daily life we incur so many small expenses like buying groceries, paying for our bus tickets, paying bills for telephone, water and electricity which may all add up to huge amounts. Paying rent, purchasing a car or paying your monthly instalments are examples of large expenses. It is normally the small expenses which go out of hand and is difficult to keep track of them. Recording these transactions will help you sum up your cash outflows.

flow statement for the last month. Arun does not have any other source of income from interest or dividends. He has expenses like travelling to his place of work, he pays . 3000/- as conveyance p.m. to the taxi driver, his mobile telephone charges costs him. 1000/-, he contributes . 5000/- to household kitchen expenses, he decides to buy a gift for his parents for. 2500/- from his first earnings and `. 3000/- he spends on tea/coffee with his friends.

Personal cash flow statement for Arun

Cash inflows Salary 27, Interest on deposits 0 Dividend income 0 Less income tax 2000 Total cash inflows 25,

Cash outflows Travelling expenses 3000 Mobile telephone 1000 Household expenses 5000 Parents’ gift 2500 Recreation (tea/coffee) 3000 Total cash outflows 14,

Net Cash Flows 25,000-14,580 = `. 10,

The excess cash of `. 10,500 he can allocate to savings and other purposes. Basically, to increase your net cash flows you will either have to earn more or spend less, i.e., maximize cash inflows and minimize cash outflows.

Factors affecting cash flows We will have to analyse both cash inflows and cash outflows. It is only the net cash flows which enhance your wealth since you can save it or invest it further to earn a higher income.

Cash Inflows Your income is the major source of cash inflows. Your qualifications and the stage at which you are in are the two factors affecting your income level. Then other sources are interest income, dividend, rent from property etc. Stage in career path People at initial stages of their career earn a lower salary. As they grow and develop in their career, their salaries increase, allowances increase, their experience enables them to get other higher post jobs, etc. This normally has a direct correlation with your age. The older you get your salary structure and status improve. But it may so happen that when jobs are changed older people do not get the commensurate salary. Your cash inflows or your salary therefore depends upon your career and the stage of your career. Type of job Some jobs are very well paid. In India, professionals or people with specialized skills earn much more. Engineers, management professionals, lawyers, are usually paid higher salaries. Doctors who are also highly qualified, unfortunately, in India, are not well paid. If you are self employed, then your cash inflows will depend upon the hard work and the time, energy and dedication you put into your work. Number of working people in your household The households’ cash inflows also depends upon the other earning members in the household. Obviously, the household with more than one income earner will be more comfortable and the total cash inflows will increase.

Cash Outflows Cash outflows are the expenses incurred on various items and assets. These depend upon the person’s family size, age and consumption patterns.

exceed your income (cash inflows) and you will have to make some kind of arrangement either borrow or pay through your credit card to cover your extra expenses. If you know in advance what is to be done, you are better prepared to face the situation.

In the same example taken earlier, suppose Arun anticipates his spending to go up next month by . 1000/- due to extra travelling and he would have to pay. 12,000/- towards his father’s medical treatment.

Revised personal cash flow statement Cash Inflows Next month Last month Salary 27,000 27, Interest on deposits 0 0 Dividend income 0 0 Less income tax 2000 2000 25,000 25, Cash Outflows Parents’ gift - 2500 Travelling expenses (1000) 4000 3000 Mobile telephone 1000 1000 Household expenses 5000 5000 Recreation 3000 3000 Medical treatment 14000 - 27,000 14,

Net cash flows (-2000) (+10,500)

Thus, we see that next month there is an unexpected cash payment of medical expenses for which Arun will fall short by `. 2000. He then has to arrange for this contingency.

Create your own budget Assess your monthly expenses. Make sure you record all your regular monthly expenses, including what you spend on eating out, entertainment and hobbies. Total your earnings. Calculate how much you make per month, including any money that you receive from investments and other forms of residual income. Match your expenses with earnings. This will test how effective your budget is and how much you have left over at the end of the month. Rework your budget. If your expenses exceed your income; you will have to cut down unnecessary expenses. Keep some money for debt reduction. Your budget should have provision for paying off your debts each month. In case of huge debts it is better to sacrifice and make a lump sum payment. A part of your income may be saved for an emergency, retirement investments, vacation, family celebrations, etc. These financial goals may be highlighted in your budget. Put your budget to work. Now that your budget is ready covering all expenses and financial goals, make sure you follow it and live within it. Assess your budget If you are not able to live within your budget, you need to limit your spending and rework your budget. Be realistic about your spending habits.

Why prepare a budget? Preparing a budget actually helps in anticipating cash shortages, checking the accuracy of the budget and forecasting net cash flows for future. Anticipating cash shortages If you are likely to have a cash shortage in the next month you can make arrangements to overcome it. Maybe you could withdraw funds from another account and manage somehow. If the amount is large, you might need to borrow from a friend or relative or maybe take a loan against a fixed deposit or dissolve the fixed deposit. The deficiency can be covered if one is